Portfolio Management Strategies
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Index Options - Tools for Portfolio Management
As an investor, you may be familiar with options on individual stocks, where you have the right to buy (call option) or the right to sell (put option) a particular stock at some predetermined price within some predetermined time. The buyer has the rights and the seller the obligations. With index options the basic ideas are the same. However, index options allow you to make investment decisions on a specific market industry or on the market as a whole. Investment strategies can be made with index options similar to those made with individual stock options.
There are two types of index options:
An index call option gives the buyer the right to participate in market gains over and above a predetermined strike price until the contract's expiration. The buyer of an index call option has unlimited profit potential tied to the strength of the index's advances.
An index put option gives the buyer the right to participate as the underlying index falls below a predetermined strike price until the contract's expiration. The buyer of an index put option has substantial profit potential in the event of a downturn.
In exchange for these "rights," the buyer pays the seller a price known as the premium for the option If an option is trading at 5.125, the buyer would pay $100 times the premium quote, or $512.50 per option. The buyer's risk is limited to the amount of the premium. The seller of an option receives the premium from the buyer; this premium is the maximum profit a seller would realize from the sale of the option. The potential for losses in option selling is generally unlimited; any investor considering selling options should recognize that there are significant risks involved.
Index options have strike prices that are set at intervals from one to ten points. The relationship of the index to the option's determines whether the option is referred to as in-the-money, at-the-money or out-of-the-money. A call option is
in-the-money when the index level is above the strike price. It is at-the-money when the index level is equal to the strike price and out-of-the-money when the index level is below the strike price. If you bought an index put with a strike price of 75.00, you participate in moves in the underlying index below 75. A put option is in-the-money when the index level is below the strike price, at-the-money when the index level is at the strike price and out-of-the-money when the index level is above the strike price. CBOE will typically list in-, at- and out-of the-money strike prices. New strike prices are added in response to market movement in the underlying index.
In the case of a call, if the underlying index is above the strike price, the buyer may exercise and receive the amount by which the call is in-the-money at expiration. For example, with the settlement value of the index at 79.55, the buyer of a call with a 78.00 strike price would exercise and receive $155 [(79.55 - 78.00) x $100 = $155]. The seller of the option
would pay the buyer this cash amount. Results vary, based on the settlement value at expiration. Settlement value, in this example, is calculated based on the opening prices of the component stocks on the last business day prior to expiration. Your call break-even point is an index level equal to the strike price plus the premium. The higher the underlying index settlement value is above the break-even point at expiration, the higher your profit. If the settlement value at expiration is under the break-even point, however, you lose all or part of the premium. The maximum you can lose, as a buyer, is the amount of the premium.
In the case of a put, if at expiration the index is lower than the strike price, the holder may exercise and receive the in-the-money amount. For example, with the settlement value of 74.88, the buyer of a put with a 78.00 strike price would exercise and receive $312 [(78.00 - 74.88) x $100 = $312]. Again, the amount of profit or loss is determined by how much lower the underlying index is than the strike price at expiration, with the maximum loss being the premium amount. Your put break-even point is an index level equal to the strike price less the premium paid.
Index options are cash-settled, meaning no actual stocks are ever bought and sold on behalf of the option buyer. Index options can have a European-style or American-style exercise. European-style index options can be exercised only at expiration while American-style index options can be exercised at any time prior to expiration. From the perspective of an option seller, it is impossible to be assigned an exercise notice on a European-style option until the option's expiration. Index options are expiring assets in that they do not provide "rights" to the buyer indefinitely. Unlike stocks, which buyers can hold forever if they choose, index options expire or cease to exist on the expiration date. The buyer can choose from several expiration dates, depending upon his investment objective and the timing of his market forecast. Expirations are available up to three near-term months plus up to three months on the March quarterly cycle (for example, October, November, December, March, June, September). Index options can be either held until expiration or sold on the floor of CBOE during regular trading hours.